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Dysfunctional Sovereign Debt Politics in Lebanon, Italy, and [Your Country Here]

posted by Mark Weidemaier

Mark Weidemaier & Mitu Gulati

Debt, like the full moon, is known to make politicians act strangely. There have been some good examples over the last few weeks, most recently in Lebanon and Italy.

Let’s begin with Lebanon. The country has a huge foreign currency debt stock, dwindling capital reserves, and one of the highest debt/GDP ratios in the world (here, here and here). Investors are concerned, and this is reflected in yields on Lebanese bonds and in the prices of CDS contracts, which reflect an estimated 5-year default risk of around 80%. Last week, Lebanon made a large principal payment on a $1.5 billion bond that had matured, and then turned around and borrowed more, issuing two new dollar bonds with a total principal amount of around $3 billion. These moves bought time, but at the cost of further straining the country’s scarce foreign currency reserves and adding to its debt burden. Why not instead simply ask for an extension of maturities on the existing bonds, buying time to devote resources to something other than debt service?

This head-in-the-sand approach is pretty typical. Politicians often delay debt restructuring far longer than they should. No award goes to the politician who recognizes and addresses a debt problem early, when it is still manageable. A politician who utters the word “default” is likely to get tossed out of office before the benefits of timely action become clear. And while in an ideal world, international financial institutions like the IMF might help produce better decisions, that rarely happens.

But it’s not just that the Lebanese government won’t acknowledge the problem. For some years, the government has delayed obvious reforms to its bond contracts that would have made a restructuring easier to manage.

Starting in 2014, the rest of the world began issuing bonds with so-called single-limb Collective Action Clauses (CACs), which let a distressed sovereign restructure its debt in an orderly fashion with minimal need to worry about disruptive holdout creditors. These clauses are especially valuable for sovereigns that issue debt in foreign currency and under foreign law. Countries who adopt single-limb CACs mitigate the risks of a future debt crisis without suffering any negative consequences in the market. It turns out that investors in the primary markets actually like these clauses; they don’t want their lunch eaten by holdouts at some later stage.

Once single-limb CACs became the market standard, there was no good reason for Lebanon not to use them. Yet the government continued to issue bonds with older, less functional collective action clauses, and these will not reliably work to eliminate holdouts in a restructuring of the country’s debt. According to a Reuters report, Lebanon has issued more bonds with the old fashioned CACs since October 2014 than pretty much any other country issuing foreign currency bonds. We haven’t dug deep in the numbers, but we haven’t seen any evidence that the market rewarded Lebanon for its refusal to adopt the current generation of CACs. Nor does it appear that Lebanon is trying to buy time to fix the problem with its contracts; its new debt is subject to the same, inadequate CAC as the old.

And then there is Italy. Less than a year ago, the Italian government appeared to have agreed— after lots of hand holding—to take a big step towards mitigating the risk of a future debt crisis. The big step was … wait for it … adopting the same, single-limb CAC that Lebanon has steadfastly refused to adopt. In connection with anticipated reforms to the European Stability Mechanism treaty, all euro area governments would have committed to adopt the new, single-limb CACs starting in 2022. But just last week, the League party seemingly decided that Italy should not go along with these reforms. So, there is some risk that Italy will veto reforms that would help better protect it in a debt crisis. It’s worth emphasizing that the whole point of these reforms is to help solve the Italian debt problem, which could threaten the existence of the euro itself.  

Some of the talk originating from Italian politicians rehashes the tired old fear that investors will punish a government that adopts the new single-limb CACs. The theory is that investors will view the adoption of the new clauses as a signal that restructuring is imminent. That’s nonsense. Investors seem quite happy to lend to Italy—so much so that investors are happy to lend huge sums under Italian local law. It turns out that over 99% of Italian sovereign debt is governed by local law. That means that Italy already enjoys a huge advantage if it needs to restructure. Inserting single-limb CACs would improve Italy’s ability to restructure in an orderly way. But as one of us has written, the improvement is not as great as it would seem; Italy already has significant freedom to restructure its debt, even if it does not formally adopt the new clauses. It is especially loony to think that investors in Italian debt would get spooked by the addition of single-limb CACs to local law bonds. Do politicians know this? We suspect so, and that they are manufacturing concern over ESM reforms to score political points with Italian voters.

Comments

Hello: Thanks for the article. I'm confused over the statements on Lebanon's "old fashioned CACs": As I understand it their CACs allow for cramming down all holders of a series as long as 75% of the holders of the series vote. 75% seems like a reasonable threshold. When you say these CACs are "less functional" are you referring to the lack of aggregation clauses or something else? Thanks!

Hello: Thanks for the article. I'm confused over the statements on Lebanon's "old fashioned CACs": As I understand it their CACs allow for cramming down all holders of a series as long as 75% of the holders of the series vote. 75% seems like a reasonable threshold. When you say these CACs are "less functional" are you referring to the lack of aggregation clauses or something else? Thanks!

John: yes, the lack of aggregation features.

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